Valuing the Environment: Concepts

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Chapter 2. Valuing the Environment Concepts
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Review
Figure 1.1 Beyond the Limits Standard Run
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Figure 1.2 Environmental Indicators for Various
Country Income-Levels
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Review True or False?

• The basic pessimist model was developed by Thomas
  Malthus.
• According to the view in the Beyond the Limits,
  the economic system will collapse in 100 years
  because of severe pollution.
• Julian Simon also believes that the resources are
  fixed.

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Review Multiple-choice

• One of the key factor that makes Julian Simon
  optimistic about the future is
• A. Pollution level will decrease as population
  increase because more and more people will
  realize the importance of protecting environment.
• B. He is a free-market economist.
• C. Everything is getting better and better.
• D. The ultimate resource is not limited and all
  future activities depend on it.

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Chapter 2Human and Environment Relationship
The Environment as an Asset

• Economists view the environment (the world and
  all of its ecosystems ) as a composite asset,
  beneficial to humans because it is combined with
  other factors of production to yield a variety of
  services.
• As an asset, we are concerned with how to
  prevent depreciation of its value as an input to
  the production of aesthetic and life-sustaining
  services.

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Figure 2.1 The Economic System and The
Environment
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Environment as an Asset

• Closed system no inputs nor outputs transferred
  outside the system
• Open systemenergy or matter imported or exported
  out of the system.
• Do our planet and the atmosphere form a closed
  system?

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Environment as an Asset
Two Physical Laws

• First Law of Thermodynamics energy and matter
  cannot be created or destroyed.
• The law implies the mass of materials flowing
  into the economic system (production and
  consumption processes) must either accumulate in
  that system (i.e. be incorporated into final
  products) or return to the environment as waste.

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Environment as an Asset
Two Physical Laws

• Second Law of Thermodynamics entropy law
  Entropy is the amount of energy not available for
  work.
• Entropy increases.
• In the absence of new energy inputs, a closed
  system must eventually use up its energy, and
  life would cease.

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The Economic Approach

• Positive economics versus normative economics

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Normative Criteria for Decision Making
Benefit-Cost analysis

• It provides a method for determining whether or
  not an action should be supported. Most simply,
  if the benefits exceed the costs, then the action
  should be supported.
• How can we measure the benefits and costs?
• Benefit can be derived from the demand curve.

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Figure 2.2 The Individual Demand Curve
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Figure 2.3 The Relationship of Demand to
Willingness to Pay
Total willingness to pay is area under
demand curve. Total Benefits is the area under
market demand curve.
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Figure 2.4 The Relationship of Marginal Cost and
Total Cost
Costs (opportunity costs)-- Marginal opportunity
costs or supply curve. Total cost is the area
under the supply curve.
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Figure 2.5 The Derivation of Net Benefits
Net benefits excess of benefit over costs
total WTP-total costs demand area-supply
area LRK (preserving 5-mile stretch)
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• If we are considering preserving a 5-mile stretch
  of river, and the benefits and costs are
  reflected in the figure, should we preserve it?
• How about a 4-mile stretch?
• How about a 6-mile stretch?

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Exercises
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Discounting the Future

• Is time an important factor?
• Forests can be harvested over time, so do
  fisheries
• Pollutants can accumulate over time
• How can we make choices when benefits and costs
  may occur over time?

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Discounting the Future

• Interest Ratecrucial link between periods
• Example Should I sell my land in the country?
• Suppose I have an offer of 100,000 now (period
  t). If I sell and put the money in the bank at
  10 interest, next year (period t1) I will have
  100,000100,00010 or 110,00.
• Suppose I do not sell this year but sell next
  year (period t1) for a price of 112,000.
• ? This would mean banking the money is not a good
  idea.

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Compounding

• Compounding is basically letting the principal
  (V) grow while interest is calculated on the
  interest earned period by period.
• Say 10 today invested at 10 interest rate will
  yield
• 11 (101010) a year from now
• 12.1 (111110) two years from now
• V(t)V(1r)t

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Discounting the Future

• Present Value (PV) incorporates the time value
  of money, translate everything into its current
  worth.
• PV of a one-time net benefit (Bn) received n
  years from now is

Where r is the interest rate
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Discounting the Future

• Net PV of a stream of net benefit B0,, Bn)
  received over a period of n years is

Where r is the interest rate
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Discounting the Future
Examples

• Investing 100 at 6 yields
• 200 in 12 years,
• 400 in 24 years,
• 3300 in 60 years, and
• 34,000 in 100 years.

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• You won the lottery! You are awarded after-tax
  income of 1M. However, this is not handled to
  you all at once, but at 100K/year for 10 years.
  If r10, net present value
• NPV100K(1/1.1)100K(1/1.1)2100K(1/1.1)9100K
• 675,900
• The value of last payment received is
• NPV(1/1.1)9100K 42,410.
• ?You would be indifferent between receiving the
  flow of 1M over 10years and 675,900 today if
  you can invest.

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Discounting the Future

• The process of calculating the present value is
  called discounting.
• Benefit-cost analysis is the approach to find the
  present value of net benefits from the action to
  see if the project is worthwhile.

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Exercise

• Example   Suppose you have 1000 to invest, and
  two characters from down at the barbershop have
  offered to cut you in on their private
  money-making schemes. Peter promises to triple
  your money in five years. Warren says he'll
  quadruple your money in seven years. Assuming
  that you are a big enough twit to believe either
  one of these scoundrels, which is the better
  deal?

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Finding the Optimal Outcome

• An allocation is efficient or has achieved static
  efficiency if the net benefit from the use of
  those resources is maximized by that allocation.
• If at an allocation, marginal cost is greater
  than marginal benefit, net benefits are less than
  the maximum possible and the allocation is
  inefficient (too much has been produced).
• If marginal benefit is greater than marginal
  cost, net benefits can be increased by increasing
  the allocation. Inefficient allocations do not
  maximize net benefit.

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Finding the Optimal Outcome

• The first equimarginal principle says that net
  benefits are maximized when the marginal benefits
  from the allocation equal the marginal costs.
• But is it fair?
• Fairness in economics is achieved by encouraging
  actions that increase benefits of someone without
  reducing the benefits of someone else.

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Finding the Optimal Outcome

• An allocation is Pareto optimal if no other
  feasible allocation could benefit some people
  without any negative effects on at least one
  other person.
• Allocations that do not satisfy Pareto optimal
  are suboptimal.        
• An allocation has achieved dynamic efficiency if
  it maximizes the present value of net benefits.

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Applying the Concepts Table 2.1
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Applying the Concepts

• Choosing between Preservation and Development in
  Australia